Unravelling Derivatives

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Two chief developments have brought about a renewed interest in the derivatives markets. One- the introduction of 14 new stocks in the derivatives markets. Two- an increasing trend in options trading, especially of Nifty junior. Though the introduction of 14 new stocks has invited flak from the broker and the analyst community alike, there is an underlying point in the two developments: an accurate understanding of investment parameters in order to milk the investment options at hand.

Explains Manoj Mudliar, a derivatives analyst of a leading brokerage, “The derivatives market is growing and is catering to complex needs of users, in sufficient quantities. Hence, investors need to get their understanding of the investment parameters right to read the trend projected by the markets.” Of all the investment parameters, open interest (OI) is an important barometer used to confirm trends and trend reversals for futures and options contracts.

It is the total number of outstanding contracts that are held by market participants at the end of the day. It can also be defined as the total number of futures contracts or options contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery. It applies primarily to the futures market.

OI measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus, a seller and a buyer combine to create only one contract.

Therefore, to determine the total open interest for any given market you need only to know the totals from one side or the other, buyers or sellers, not the sum of both. To give an example, suppose you buy one contract of Reliance 230 calls from an investor A, the open interest is one contract, as is the volume in that option. Subsequently, if you immediately sell the 230 calls to another person, the volumes will increase to two contracts.

The open interest, however, remains at one. The reason: As you have sold an option that you bought earlier, you are out of the market, while another person has entered for the first time. So, this new trader is long one contract, while you are still short one contract. Therefore, the open interest is only one contract.

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